Don't be surprised to see the Fed give inflation some leeway
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Now that the economy has, by and large, completely recovered from the Great Recession and the Federal Reserve has started to raise interest rates in earnest, what is the new normal for monetary policy? 

Two fairly technical, but potentially quite significant new research papers presented by Fed researchers at the Brooking Institute this week respond to these questions.


Although the papers deal with strategic questions for the Fed, they got some attention in The Wall Street Journal. In a central banking world that aspires to be boring, the suggestion that it might be OK to tolerate inflation of 3 percent is downright sensational.


So allow me back up and explain. The Fed has finally started to raise the main interest rate it influences, the federal funds rate. To the monetary policy world, the Fed’s two recent quarter-percentage point increases in the rate are pretty big news.

After seven years of rock-bottom rates from late 2008 to late 2015, the Fed has now taken three small steps upward. The federal funds rate is now targeted between 0.75 percent and 1 percent.

The immediate question is: how far should the Fed go? The strategic question is whether the Fed should change the approach it has followed up to now in light of the slow recovery since the 2008 financial meltdown.

The first paper, by four New York Fed economists, suggests that Fed does not need to restore interest rates to anything like the pre-crisis level of 5.25 percent. Del Negro, Giannone, Giannoni and Tambalotti argue that forces in both the domestic and global financial systems have greatly lowered the “natural” rate of interest that would be a suitable target during good times.

Many different major actors in the world economy have increased need of extremely safe and liquid assets. These actors include major central banks in Asia who look to support their currencies, sovereign wealth funds, oil producers and a range of hedge funds and asset managers.

These are the folks who created the “global savings glut” identified by former Fed Chairman Ben Bernanke as far back as 2006. According to the four authors from the New York Fed, demand for U.S. Treasury bonds and similar assets have depressed the natural rate of interest in the U.S. by about 2 percentage points.

This is a big decrease. According to the authors’ calculations, this means that the Fed will most likely not want to raise the fed funds rate to anything more than about 3 percent — much less than in pre-crisis days.

Although this paper’s methods and arguments are novel, the authors’ conclusions are similar to a number of studies coming out of the various Fed banks’ research departments in the last year or two. The more newsworthy paper is the one that discusses strategy.

Michael Kiley and John Roberts of the Fed Board of Governors explore the implications of lower fed funds rates on the likelihood of reaching the “effective lower bound” — the lowest rate the Fed can push the fed funds rate to.

Before the recent crisis, conventional wisdom held that the fed funds rate could not go below zero. People spoke of the “zero lower bound”. However, the experience of several central banks, including such heavy hitters as the European Central Bank and Bank of Japan, have shown that central banks can actually set negative interest rates on both deposits and loans in these low-interest rate times.

Literally, banks will pay the central bank to take their deposits, and the central bank will pay banks to take loans. Banks pay less to deposit their massive money holdings at the central bank than they would have to pay to actually hold the stuff as cash. The central banks can actually get away with charging them to make deposits. Topsy-turvy but true.

The backstory to this situation is the threat of a sustained decrease in the average prices of goods and services, also known as deflation. Economics professors like me teach students that deflation can be extremely dangerous.

When consumers and firms expect that prices will keep falling, they may postpone purchases, pushing the economy into deeper recession. Falling prices also make it even harder for debtors to repay loans. The experience of the U.S. in the early 1930’s and Japan after 1999 are good examples of the dangers of a deflationary spiral.

However, since 2009, the worst case of a deflationary spiral was averted, in part by “unconventional” monetary policy measures, or quantitative easing. After they pushed interest rates to the effective lower bound, Central banks bought massive quantities of Government bonds. They also made promises not to raise interest rates when the economy began to recover.

One of the questions Kiley and Roberts pursue is whether the techniques the central banks employed are potent enough that policymakers no longer have to fear those periods when interest rates reach the effective lower bound floor.

They present two findings: first, their mathematical modeling suggests that the economy remains well below its potential for significant periods of time when the floor is hit. These episodes are not benign, and the new tools of monetary policy are not so potent.

Even if deflationary spirals like the 1930’s can be avoided, prolonged periods of low output, high unemployment and low inflation result from periods of very low inflation.

The second finding from Kiley and Roberts’ array of simulations is that an economy in which the Fed only aims at a 3 percent fed funds rate is much more likely to hit the floor.

This is also a new and troubling finding. In one simulation, the chances of hitting the floor rise from a modest 5.1 percent to a rather troubling 31.7 percent when the natural rate of interest rate is not 5 percent but 3 percent.

The paper contains an extensive range of simulations to see just how sensitive these conclusions are to various aspects of the statistical approach, but the overall message is clear — in a low-interest rate world, the economy is likely to drop to the floor frequently, and the current policy approaches do not move it off of the floor quickly enough.

How serious is the problem? Current Fed policy, much like policies of other leading central banks, tries to bring inflation to a target of 2 percent. But, if the economy is very prone to fall to the floor, while Fed policymakers refuse to tolerate inflation above 2 percent, the economy will end up spending more of its time in the doldrums than in a robust state.

In its quest to prevent the economy from overheating and inflation from taking off, the central bank creates a situation where the average condition of the economy is sub-par. Inflation averages less than 2 percent, unemployment is higher than it needs to be, and output is below potential.

Kiley and Roberts suggest that the Fed should actually take into account how deep the doldrums are. Policy approaches need to develop memory. The economy should be allowed to overshoot the 2 percent inflation target, so that the highs average out the lows.

This would also give a boost to output and employment. They are not the first to suggest this, but their proposed calculation of a “shadow” interest rate gives very specific guidance about when the Fed should start to raise interest rates. Later rather than sooner is the result.

The stickiest point here is whether the Fed would be able to convince the public that the increased inflation is temporary. Public confidence in the Fed’s commitment to strictly limiting inflation has been very hard won, and it could easily be lost.

Kiley and Roberts suggest that there would be a learning process the first time such a policy was implemented, but that the public might get used to these temporary bursts over time. However, it is very difficult to predict and model this process precisely.

In reality, we may be about to witness such a period of overshooting. Inflation measured by the Fed’s favorite indicator, the Personal Consumption Expenditures Index, jumped from 1.6 percent in January to 1.9 percent in February. I would not bet against inflation rising above 2 percent in the next months.

For the moment, sharp accelerations in inflation seem quite unlikely. While the headline unemployment rate is low, there are still unusually large numbers of workers out of the labor force that might be available for work.

Wages have been increasing, but not at worrisome rates. There are signs of upturn in much of the world economy — The Economist had a cover story about the world economy’s “surprising rise” recently. But this is a far cry from a boom.

Looked at from the scholarly point of view, Kiley and Roberts’ arguments make sense. Their numbers come out nicely. If things go well, the modest overshooting of inflation will not raise a lot of eyebrows.

Compared to a lot of other things going on around us, the possibility of the Fed tolerating a little more inflation does not seem too upsetting. But that is only if things go well.


Evan Kraft specializes in the economics of transition, monetary policy and banking issues as a professor at American University. He served as director of the research department and adviser to the governor of the Croatian National Bank.

The views expressed by contributors are their own and not the views of The Hill.